McKinsey's Q&A on China

An excerpt on McKinsey's view on China
For full article see http://www.mckinseyquarterly.com/

What executives are asking about China
The head of McKinsey’s office in China answers the senior executive’s most pressing questions about doing business there.
Gordon R. Orr
The McKinsey Quarterly, 2004 Special Edition : China today

The stability of the banking system, the protection of intellectual property, and adherence to trade commitments are just a few of the long-term issues facing China. They are also the foremost problems in the minds of senior managers of multinational corporations that are already there, contemplating expansion, or considering whether to jump in for the first time; international investors worry about them as well. The following questions and answers, based on McKinsey's experience working with China's government and with Chinese and foreign companies doing business in the country, offer a view of how the country is handling these and other long-term concerns.

What is the condition of China's financial system?
Our view is that most banks are performing much better today than they were a few years ago, although they are carrying massive amounts of bad debt from the days when their primary role was to help maintain employment by supporting state enterprises. Today banks have improved their operating systems and skills, and they have a much stronger risk-management culture.
Indeed, banks are on a strong upward trajectory, and many are quite profitable: in 2003, two of the largest—Industrial and Commercial Bank of China and China Construction Bank—earned operating profits of more than $7 billion and $2.5 billion, respectively. The government-regulated interest-rate spread between deposits and loans gives these banks an enormous margin, one of the largest in the banking world, and they are using it to write off bad debt. Regulators understand the importance of this interest-rate spread, which will remain in place for several years. The potential spread has actually increased this year as banks, for the first time, have been allowed to charge higher rates to riskier customers.
In addition, banks are making money on most of their new commercial loans, though favorable market conditions have helped a great deal—you generally don't see many defaults in an economy growing at 9 percent a year. It remains to be seen whether the improvements in commercial risk management will be robust enough to cope with a weaker economy.
For the big state banks, capital injections to clean up balance sheets before shares are sold to the public also promote the write-off process. Smaller banks are receiving infusions of capital and capabilities from Western investors. Overall, we believe that the chances of a banking crisis are receding.
The real challenge most banks face is the need to prepare for a drastic shift in their sources of profit. Today virtually all profits come from deposit taking and commercial lending. In ten years, retail credit, fee-based activities, and lending to small and midsize enterprises will probably account for about half.
But most Chinese banks have few of the skills needed to compete in these new business areas. They generally lack retail risk-management skills, so the small amount of retail lending undertaken today is generally unprofitable. Some banks are improving their capabilities rapidly and benefiting from foreign capital—Citibank and HSBC, for example, are investing billions of dollars in Chinese financial institutions. But the majority of local banks must do much more to capture the growth available in the market and to compete against international banks that will be able to enter it more freely in 2007 as a result of China's commitments to the World Trade Organization.

Where does China stand on its commitments to the WTO?
December 2004 will mark the third anniversary of China's accession. Over the past three years, the country has moved to meet the core commitments it made at the time of entry, and it is largely on schedule. Nonbank auto finance companies have been established, for example, foreign life insurance companies have been permitted to operate in more cities, retail opportunities have opened up, and regulators act far more transparently. The one major case in which the United States took China to the WTO for violating a resolution—refunds of value-added taxes on semiconductors—was recently resolved. China is also opening itself up much more extensively to foreign agricultural products, including genetically modified ones. Farm exports to China, such as soybeans from the United States and Brazil, are therefore increasing rapidly. What's more, the country is becoming adept at using the WTO rules to its advantage, with about 20 investigations begun last year, mainly against Japan and South Korea.
The financial sector is expected to open up largely as planned, with the major changes coming in 2007, when greater foreign involvement in domestic retail banking will be allowed. Also scheduled for liberalization are the various forms of asset and funds management, but this move is likely to have a less immediate impact, since the subsector is relatively small today.
In a number of instances, different sorts of barriers remain. So, for example, while foreign retailers can establish stores almost anywhere, they must meet local-planning requirements to fit in with a city's financial and development programs. Unfortunately, these requirements are vague and open to subjective implementation.
Also, in several sectors—including telecommunications—the regulatory function still hasn't been fully separated from the government or the operator. The resulting conflicts of interest may hurt competition and, at a minimum, add to the kind of uncertainty that can hold back investors. The Chinese government could enhance its credibility among foreign investors by accelerating the move to more clearly separate regulators and by encouraging them to operate more transparently.
The resolution of the semiconductor dispute suggests that beneath the rhetoric, neither the United States nor China wants to rock the boat
In any case, trade conflicts will continue to arise; the recent conflict over imports of Chinese furniture into the United States is an example. But the resolution of the high-profile semiconductor dispute suggests that beneath the rhetoric, neither country really wants to rock the boat. Although the United States runs a big trade deficit with China, US exports to it have been growing by 30 percent annually since it entered the WTO. Exports from China to the United States rose by almost a third from 2002 to 2003 alone. Trade is also growing strongly between China and the European Union, Japan, and China's neighbors in Southeast Asia.
To what extent are gaps in the protection of intellectual property holding back foreign investment?
At some level, money speaks louder than words. China's $53 billion a year in foreign direct investment suggests that foreign executives find the situation at least manageable, though clearly nothing to celebrate. The core issue is enforcement. The central government has largely followed through on its WTO commitments by creating a stronger policy framework for protecting intellectual property. However, the will and the ability to enforce the policy at the local level are often modest, to the continuing dismay of many foreign investors.
Foreign companies are moving to protect their intellectual property by setting up wholly owned enterprises, now that requirements for joint ventures are diminishing in most sectors. The absence of a partner looking over your shoulder obviously reduces opportunities for infringement but still leaves open the possibility that a product could be duplicated later on. In general, a wholly owned enterprise gives much greater protection for process-based intellectual property than for products.
There are still high-profile examples of intellectual-property theft, such as the copying of a complete foreign-car design. Fake DVDs remain readily available, as do counterfeit golf clubs. And, clearly, in some cases consumers or businesses believe that they are buying legitimate products but actually get poorly performing counterfeit ones. This can damage the image of a brand and remains a big concern, particularly in consumer goods. Procter & Gamble, for example, notes that businesses that actually export counterfeits have sprung up in the past two years.
But as retail channels become more professional, fake products are unlikely to take as large a share of the market as they did in the past. Counterfeit goods are more likely to end up in kiosks or mom-and-pop shops than on the shelves of the Chinese stores owned by the world's largest retailers. The number of intermediaries in the supply chain may even drop to zero, with manufacturers delivering directly to retailers, thereby eliminating the chance of counterfeiting. There is a similar trend in high tech: as Dell's direct-sales model takes off and is copied by others, distributors no longer have opportunities to install fake hardware or software in PCs. Customers—including government departments—that want genuine products with guarantees are learning to buy direct.

What progress have Chinese companies made in improving their corporate governance?
You have to separate the progress made by individual CEOs and CFOs from what's happening at the institutional level. Chinese executives on the whole take their responsibility for having shares publicly listed, particularly internationally, in an incredibly serious way. There is a passionate desire to understand what moves share prices and what motivates investors, as well as a serious commitment to communicating with them through road shows.
At the institutional level, less progress has been made. Strong, dominant personalities run many companies. Although this may help communicate seriousness of intent to foreign investors, these leaders are also prone to make management decisions instinctively, with little input from other senior executives or outside directors. The few independent directors tend to have less weight in corporate governance. A related problem is the issue of capital structure. Many enterprises that were once entirely in government hands have a fairly small free float—for example, 23 percent for China Mobile Communications, 21 percent for China Telecom, and 10 percent for PetroChina. Most of the remaining shares are now in unlisted holding companies ultimately controlled by the central government.
Another challenge related to corporate governance is the growing role of regulatory authorities. The financial sector's regulator, which is considered to be on the leading edge, has become clearer about rules and responsibilities and is increasingly effective in carrying out enforcement. But in energy, power, and telecommunications—where regulators play an important role in other countries—the regulators are less effective and their powers more modest. As a result, companies may put investments on the back burner because of delayed or ambiguous regulatory decisions or a continuing bias in favor of incumbents.
How much progress has China made in restructuring its state-owned enterprises?
Restructuring has advanced more quickly than is generally recognized. The contribution of state-owned enterprises to China's gross domestic product was only 17 percent in 2003, for example. Yet some of the largest state-owned enterprises have become extremely profitable: the energy company PetroChina had operating profits of $12 billion in 2003, while the telecom companies China Mobile and China Telecom made $6 billion and $4 billion, respectively. These companies, operating in infrastructure-based sectors, are world leaders in scale and help offset the losses of state-owned enterprises in declining industrial sectors. Even the basic-materials sector—coal and steel—has undergone a substantial turnaround in profitability during the past few years.
The profitability of these companies provides a financial breathing space the government can use to restructure and shrink underperforming state-owned enterprises. Meanwhile, the process of selling them off and shutting them down continues. Struggling companies tend to operate in relatively deregulated and highly competitive markets where they face both local private and foreign competitors.
A lingering concern is the concentration of declining, money-losing state-owned enterprises in places such as northeast China, where only a limited amount of industry has sprung up to replace lost jobs. Such areas have the greatest potential for social unrest.

Will China's biggest companies become competitive threats outside the country?
Potential global champions from China will come in two forms. First, the domestic giants, including the telephone and oil companies, may well expand internationally, usually on the basis of an infrastructure or license advantage at home. Companies in the telecom sector are already the world's largest in terms of subscribers. They are generating mountains of cash and have increasingly high aspirations, although they currently remain cautious about international expansion because they see it as a high-risk move that few telecom companies anywhere have managed successfully. As for energy and basic-materials companies, their priority is winning access to raw materials, and they are investing, for example, in Africa, Australia, Brazil, and Indonesia. Today they compete or partner with the world's leading resource businesses.
The second type of global champion could come from a more entrepreneurial background: companies formed as a result of intense competition in China's technology and consumer electronics sectors, for example. These companies have typically built strong leadership positions in the Chinese market over the past 10 to 15 years and now face increasingly world-class competition at home from the multinationals.
Companies in this second group have three choices. First, they can expand in China, an approach that requires them to enter new product categories, since they have very high market share in their existing ones. That could be a struggle because they, like companies anywhere, may not have the skills or knowledge to compete in new products, and price competition in many categories is already cutthroat. These companies can also expand internationally in their core product categories, taking on global players head-to-head. Some, such as Haier and TCL, are moving forward, but for most this strategy will take many years to execute, given the need to develop international marketing skills—specifically, branding and distribution. The third, and to most the least appealing, choice is to continue along the present lines and run the risk of becoming, at best, a leading regional player. That's not an attractive option for the ambitious leaders of successful Chinese companies.

As companies look to expand internationally, they face many questions: Should they grow organically? Pursue mergers and acquisitions? Sell branded or unbranded products?
But the biggest challenge these enterprises face is to develop, at the required pace, capable managers with international experience. The current leaders often have a very China-specific background. They know how to win there because they understand local consumers and businesses very well, but that doesn't necessarily equip them to compete in the global market. Identifying and developing qualified people could take a lot of time.

Can China meet its energy and food requirements?
China faces important challenges over the next few years in obtaining sufficient inputs of basic materials to sustain its economic development and to meet the broad needs of its consumers. Other than coal, China isn't rich in most basic materials, and its rising demand has recently driven up the world price of many commodities.
The need for energy sources is an important factor in China's relationships with its neighbors and with lands farther afield. Its growing ties to Central Asian countries, for example, are very much shaped by their energy reserves and by the desire to construct pipelines to its coastal areas. China has historically had close relationships with many African countries, including Sudan, and Chinese oil companies have made substantial investments to develop Africa's oil infrastructure. China's increasingly close ties with the Middle East are highlighted by the start of direct daily flights from Shanghai to Dubai and Doha. As a result of all this, there's little question that multinational oil and gas companies face more competition for access to reserves.
A parallel need is for China to expand its food supply. Urban sprawl is eating up agricultural land at the rate of one percentage point a year. Compounding this pressure is the trend for farmers to switch their production from basic cereals to value-added vegetables or livestock as Chinese consumers eat more meat and fish. Higher incomes in rural areas and the reemergence of price inflation for basic foodstuffs are recent results of this movement.
The country has thus run down its historical cereal reserves and become a major importer of agricultural products. Food imports accounted for about 9 percent of total food consumption in 2003, up from about 7 percent in 1998. Food-exporting nations and their agribusinesses will benefit from growing Chinese demand, while China could increasingly influence world commodity prices as well as consumer prices in the exporters' home countries. Such additional agricultural exports could help undercut the anti-Chinese protectionist sentiment now bubbling up in various countries.